10 Things to Know About Roth IRA Conversions

Converting a traditional IRA into a Roth account is appealing for two reasons. First, income and gains can accumulate tax-free and eventually be withdrawn tax-free. Second, a Roth IRA is exempt from the minimum required distribution rules that force you to start taking taxable withdrawals from traditional IRAs after age 70½. As we embark on what will probably be the biggest year ever for Roth conversions, here are 10 key things to keep in mind.

1. Converting Almost Always Triggers a Tax Hit.

This is the one reason why a Roth conversion is not a no-brainer: The tax rules treat the converted amount as a distribution from the traditional IRA. This usually results in an increase in taxable income and a higher tax bill.

2. The Perfect Storm for Roth Conversions.

If the value of your traditional IRA is still beaten down from the 2008 stock market meltdown, and you expect to be in higher tax brackets in future years, now might be the optimal time to convert to a Roth. You’ll pay a relatively low tax cost if you report the conversion income on your 2010 return, thanks to today’s favorable tax rates and the still-depressed value of your traditional IRA. And you’ll dodge the possibility of higher (possibly much higher) future tax rates on the income and gains that accumulate in the Roth IRA as the economy recovers. I expect these perfect-storm conditions to make 2010 “the year of the Roth conversion.”

3. No More Income Restriction on Conversions.

Before 2010, you could only do a conversion if your modified adjusted gross income (MAGI) was $100,000 or less. This year the income restriction is history -- which is the other reason I expect 2010 to become known as “the year of the Roth conversion.”

4. You Can Defer the Conversion Tax Hit.

You can choose to spread the taxable income triggered by a 2010 conversion over the following two years for federal income tax purposes. Specifically, you can report half the income on your 2011 return and the other half on your 2012 return. This procedure will defer the conversion tax hit, but that may or may not be a good idea. It all depends on the tax rates you’ll be paying in 2011 and 2012. If you expect significantly higher tax rates in those years, you might be better off following the standard procedure of reporting 100% of the conversion income on your 2010 return. Thankfully, you can postpone the decision until as late as Oct. 17, 2011, by extending your 2010 Form 1040 to that date.

5. Converting Can Jump-Start Your Roth Savings Program.

Since there’s no dollar limit on conversions, converting a hefty traditional IRA into a Roth is the quickest way to stuff a bunch of money into a Roth account and start collecting tax-free income and gains. The alternative of making annual contributions only allows you to put $5,000 a year into your Roth IRA, or $6,000 a year if you’re 50 or older.